In the first part of this series we discussed, how best debt mutual funds should be the integral part of an investor’s mutual fund portfolio in order to get higher returns than that of fixed deposits. In this part, we will discuss the other categories of debt mutual funds and also the taxation of debt mutual funds.

Long term debt funds

Long term debt mutual funds invest in long maturity bonds, both Government and Corporate. These bonds can give higher yields than short term bonds, but they are subject to interest rate risk. Interest rate risk can work both ways. If interest rate goes up, the price of long maturity bonds and the NAVs of long term debt funds fall. If interest rate falls, the price of long maturity bond and the NAVs of long term debt fund rises. Long term debt funds, over the past 2 – 3 years have benefitted from falling interest rates and top performing long term debt funds have given double digit returns

Please see here the returns of top performing income funds

If you have a long investment horizon and if you can time your entry in long term debt funds well (when interest rates are nearing their peak), you can get excellent returns. On the other hand, if interest rate rises, then long term debt fund investors will get low returns during the period of rising rates. Investors should always remember that interest rates have a cycle; a period of rising interest rates will be followed by a period of declining rates and vice versa.

Long term bonds usually give higher yields than short term bonds because the term structure of interest rates is naturally upward sloping (it is natural that a person borrowing money for a longer time, will pay the lender higher interest rate, than a person borrowing money for a shorter time). If you have a long investment tenure and an appetite for short term volatility, then you should invest in long term debt funds, because you will get superior returns and over a long investment horizon, periods of both rising and falling rates will cancel out the opposing effects of each other.

There can be different types of long term debt funds depending on the nature of underlying securities and investment strategies. Long term Gilt funds invest in long maturity Government bonds. These funds are highly sensitive to interest rate changes. Income funds can invest in both Government bonds and NCDs; they benefit from both duration calls (profiting from interest rate changes) and income accrual. Strategic bond funds employ a flexible strategy depending on the interest rate environments.

Long term debt funds are good investment options for investors who are ready to remain invested for three years or more. They can give both income and capital appreciation to investors. Investors can also benefit from the long term capital gains tax advantage of debt funds, if they remain for more than three years. Long term capital gains in debt funds are taxed at 20% after allowing for indexation benefits. The tax advantage of debt funds make them attractive investment options compared to traditional fixed income schemes.

Please check how debt funds are ideal investment option over fixed deposits

Fixed Maturity Plans

Fixed Maturity Plans (FMPs) are close ended schemes. In other words investors can subscribe to this scheme only during the offer period. The tenure of the scheme is fixed. FMPs invest in fixed income securities of maturities matching with the tenure of the scheme. For example, if the tenure of an FMP is 1100 days, then the fund manager will invest in bonds which will mature in 3 years and hold them to maturity. This is done to reduce or prevent re-investment risk. Since the bonds in the FMP portfolio are held till maturity, there is no interest rate risk. The returns of FMPs are very stable.

Post the change in taxation of debt funds announced in 2014, FMPs have a minimum tenure of three years to avoid short term capital gains tax. Capital gains in FMPs (with minimum 3 year tenures) are taxed at 20%, after allowing for indexation benefits. FMPs are suitable for investors with low risk tolerance, looking for stable returns and tax advantage over an investment period of 3 years or more. They can provide better post tax returns than bank fixed deposits of similar tenures and are attractive investment options when yields are high.

Monthly Income Plans (Debt oriented hybrid funds)

Monthly Income Plans are debt oriented hybrid mutual fund scheme where debt allocation can range from 75 to 95% and the equity allocation can range from 5 to 25%. The primary objective of monthly income scheme is to provide regular income to investors along with some capital appreciation over a sufficiently long investment. The capital appreciation can help investors beat inflation in the long term. The debt component of Monthly Income Plans lowers the volatility, provides stability and generates income for investors. The equity portion of the portion provides a kicker to returns over a sufficiently long investment horizon and can help investors beat inflation.

Though the name “monthly income plan” suggests that these schemes will make monthly payments to investors you should know that, mutual funds are subject to market risks and therefore, returns are not assured. The top performing monthly income plans have paid regular monthly dividends over the last few years. However, during exceptional market circumstances (like prolonged bear markets) monthly income plans may not be able to pay regular monthly dividends. Historical data shows that, mutual fund monthly income plans can give significantly superior returns compared to traditional fixed income products like bank FDs and post office small savings schemes.

You can check the returns of top performing monthly income plans (MIPs) in our mutual fund research section

You can also check the dividend history of Mutual Fund MIPs

Debt Fund Taxation

If units of debt mutual funds are redeemed within 36 months of purchase, then short term capital gains is calculated by subtracting the purchase cost from sales consideration. Short term capital gains is added to the income of the investor and taxed as per the income tax rate of the investor. If the units are redeemed after 36 months from the date of purchase then long term capital gains apply. Long term capital gains for debt mutual funds are calculated by subtracting the indexed cost of purchase from the sales consideration. The indexed cost of purchase is calculated by multiplying the actual cost of purchase with the ratio of cost of inflation index in the year of redemption and the year of purchase. Cost of inflation index table is published by the Reserve Bank of India and is available in the public domain. Long term capital gains for debt mutual funds are taxed at 20.6% (including education cess) after indexation.

See how we have shown the calculation of capital gains in this tool

To know more about taxation on mutual funds, do read – the tax benefits of mutual funds versus other investment options

Conclusion

In this 2nd part of the article, we discussed different types of debt funds and their suitability for various investment needs, so that you can select the best debt mutual funds for your investment.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.